Sunday, March 04, 2007

'Rationality', Prices, Markets and Adam Smith

How markets work is not widely understood, despite a couple of centuries or so of their study by what became in the 19th centuries the discipline known as economics. I could go further and say that the more economists studied markets and fitted them into their neoclassical theories, the less they understood them in practice.

I do not say that lightly or flippantly. It is not that the neoclassical theory of markets is wrong – it is backed by the clearest of mathematical rigour imaginable – and cannot be faulted on its assumptions leading to the rigorous consequences of those assumptions, plus the laws of maths. No the problem is far more fundamental: the impeccable theory isn’t applicable to the phenomenon of real world markets.

Consider the following piece, post by Mitch Fincher posts on his Blog, 'The Distracted Programmer’:

“The closer Shell station is selling gas for $2.30 and the adjacent Chevron is at $2.31. Oddly, the Chevon had three cars filling up and the cheaper Shell station had only two. I've seen these two stations which share a parking lot vary by three cents. How can the price vary so much between two adjacent stations, when Adam Smith's invisible hand tells us that people would flock to the cheaper price? It's because the gas station owners know that the American car driving public are slothful creatures of habit. We will fill up at the same station regardless of the price - we are just too lazy to look out our windows, compare the prices and do a subtraction.”

Now, it’s no use carping that Mitch Fincher does not write for the Quarterly Journal of Economics or AER or any of the other mainline refereed journals (more joining each month) by which the economics profession is blessed. That’s not the point. Young Turks of the profession in a hurry to dismiss old fogy’s and our failings in matter of their high theory, might simply sigh and mutter the words ‘irrational behaviour’ with a shake of their heads, as if that told us anything other than their mantra of their theory of rational behaviour.

The point raised by Mitch Fincher is one possible observation of the mass ‘irrational’ behaviour that millions of consumers exhibit each hour across the entire planet; in fact, more people display what neoclassical economists learn from Econ 101 to call ‘irrational’ behaviour, than any number of the wooden chess-piece movers in Chicago, and all point of the compass to which they have spread their wares, can point to examples of their rational assumptions operating in the real world (and no cheating in your counter-examples, please).

Once economics was separated from political economy (and before that from moral philosophy) it entered the dry gulch canyon of abstraction from real life. Proponents stopped looking outside their windows.

Mitch Fincher is only asking why his understanding of economics, via a theory attributed to Adam Smith (itself the product of Chicago Adam Smith, who had little to do with the Adam Smith of Kirkcaldy) appears to be wrong in practice. A perfectly fair question, I should think. I shall answer it as fairly.

Note the following extracted from Mitch’s piece: “Adam Smith's invisible hand tells us that people would flock to the cheaper price”. Now, from where did he learn this notion and forget about lags (movement is not at infinite velocity)? This use of the invisible hand certainly wasn’t from anything Adam Smith wrote. But I’m sure we all recognise it from what is repeated in Economics 101 (and onwards; even in articles in the above mentioned esteemed journals).

And with just as big a ‘but’ we can be sure that Smith never had an invisible hand theory of price determination. No Sir! You can check it out by reading Books I and II of Wealth Of Nations, where price determination is introduced and discussed and its associated consequences, and you will not find a single reference by Smith (nor even by his numerous editors) to ‘invisible hands’ as having anything to do with prices, or markets. You have to go to Book IV of Wealth Of Nations to find Smith’s sole reference to ‘an invisible hand’ – and his reference had nothing to do with prices or markets.

It is not Adam Smith’s ‘invisible hand’ that is under siege by the commonly perceived behaviour of people in markets to act ‘irrationally’; it is the neoclassical cardinal assumption of rational behaviour that is challenged by the evidence.

Years ago, as junior lecturer, I did some research into the wage differentials in the engineering sector among small workshops (under 100 employees) in the east-end of Glasgow and I found in one area little engineering workshops, who employed machinists, fitters, tool-makers, etc., all employed on different hourly rates of pay for more or less the same skill sets. While all reported some turnover of skilled and semi-skilled workers, the numbers were small; the bulk of their workers remained where they were irrespective of their wage differentials compared to workers literally across the street, and certainly near by. Why?

The reason is similar to Mitch Fincher’s drivers when buying petrol from adjacent stations with a choice of cheaper or more expensive petrol within sight. Price is not the only factor of a price choice. Now, it is in the theory of price: all other factors are held still and the quantity demanded changes to changes in price. But all other influences on the quantity demanded and from where it is demanded don’t stand still in the real world. And some of these excluded factors are more influential on some consumers than on others. Ceteris is seldom paribus.

If I approach a petrol station and I see three cars waiting at one of them and only two cars at the other, I might consider 1p price difference not worth waiting for. Am I acting ‘irrationally’? If I’m in a hurry but the price difference is 5p a litre, I might join the longer queue; I might not if I am late to pick up my children at school.

I drive regularly on the motorway of France and the government (kindly?) posts lists of prices for different brands of petrol at intervals along stretches of the road when approaching a petrol station. The signs show the price ahead and the (often different) prices at stations beyond the next one. Drivers can decide whether to pullover at the first station or drive on to the next one or two ahead. In twenty years, I have never decided on where to stop for petrol based on price and distance. I have never heard of anybody else doing so.

To call this irrational is weird. Consumers enter markets with all kinds of motives, of which price may be one. We are not guided by ‘an invisible hand’ to do or not do something. Our actions have consequences; some of them result in benign and some malign outcomes for ourselves and for others, and by extension for society (for malign outcomes from individual actions see Smith’s Book IV – which includes the metaphor of ‘an invisible hand’on page 456). The overall outcome is in principle identifiable, and in terms of markets it is thoroughly understood and explained by Smith without reference to ‘rationality’. Smith says we all try to ‘better ourselves’, but leaves open how we see betterment affecting us.

It is in the uncoordinated, unordered, and uncontrolled actions of six billion people that produce the myriad of outcomes each day that constitute a day’s experience in the lives of the participants. Markets are part of those experiences for good or ill.

Smith’s main point was that where markets are free of interference by wrong-headed policies imposed by misled legislatures, by merchants and monopolists pursuing restrictive, coercive and price rigging conspiracies against consumers, by criminals breaking the law, exercising frauds and cheating, and the proportion of net revenue from economic activity that goes to savings/investment (including investment in the necessary cardinal purposes of government – defence, justice, public works, education, health and minimal administration) is greater than the proportion going to prodigality and wasteful consumption, including wars for trivial ends and taxation for activities which the markets can do better, then society moves towards greater opulence for the bulk of the working population, in peace and security, through the phenomenon of ‘growth’.

Hayek called this ‘spontaneous order’; I prefer to call it ‘emergent order’ – it’s a process not an event – but call it what you will, it had nothing to do with a metaphorical quip that was Smith’s ‘holding job’ until someone would come along and compete the work he had began.